Did Republicans Just Force the Fed Into QE3?

Mitch McConnell, the leading Senate Republican, has ventured to grab control of the debt and deficitnegotiations that have devolved into a cat-herding exercise. On Tuesday, McConnell first took to the Senate floor to declare that there can be no real deficit deal "as long as this President is in the Oval Office." Later in the day, he floated a plan that would end the debt ceiling stand-off by giving the White House the ability to raise the debt limit without Congressional approval, as long as any increase in the ceiling is paired with recommendations for equal amounts of spending cuts.

That said, McConnell's plan is generating plenty of pushback from the far-right within the Republican party; late Wednesday House Majority leader Eric Cantor suggested it was DOA. But it remains to be seen if that's true, or just a negotiating ploy to get more out of the compromise idea. One of the more controversial aspects of McConnell's proposal is that there would be no requirement that any recommended spending cuts by the president accompanying a request to raise the debt limit would have to be enacted. So basically all this plan does is kick meaningful deficit reduction talks down the road, all the way past the 2012 elections.

I won't get into the political implications of all of that -- CBS' Political Hotsheet has a rundown of the potential winners and losers -- but it could raise the risk that the economy can't kick itself into higher gear.

Punting to You, Ben
By effectively tabling all deficit and debt reduction until after the 2012 election, McConnell isn't doing the economy any favors. No one is making a case for deficit cuts that would go into effect right now; those would be sure to sink the economy. But by agreeing to a meaningful long-term deficit reduction plan that would not kick into action until 2013, we -- and that's a global "we," given our dependence on foreign investors to buy significant chunks of our Treasury debt -- would have some clarity and progress on getting our financial house in order. Without that in place, it's just another reason for everyone to sit on the sidelines and worry. There's 16 months until the 2012 elections. That's a long time to just keep muddling through when we've got a slowing economy and 14.1 million unemployed.

But if that's how things play out, it sure looks like it could force the Federal Reserve's hand. Because when Congress can't rise to its job to deal with fiscal policy, it increases the need for the Fed to jump into action with monetary policy when things aren't going well (see: the early rounds of the 2008 financial crisis). And yesterday, amid all the deficit and debt sturm und drang, Fed chairman Ben Bernanke was up on Capitol Hill for one of his scheduled rounds of Q&A with the House. Today he repeats the exercise with the Senate.

This time, Bernanke wasn't as emphatic as he has been that the economy is going through a "transitory soft patch." Instead, he seemed to open the door a bit more to the idea that the economy might need more Fed easing to keep it from backsliding into a double dip:

"The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support."

Is That QE3 on the Horizon?
While the stock market spent Tuesday and most of Wednesday giddily anticipating a third round of quantitative easing, the reality is a lot more has to happen before we get QE3. And none of it good. The only way we get QE3 is if we see economic growth continue to slow and inflation threaten to turn into deflation. The absence of a long-term deficit deal just makes both those things more likely. Though to be clear, there are plenty of other reasons why the economy could stall out, including the huge consumer debt hangover.

One interesting tidbit from Bernanke's Capitol Hill testimony was his musing on what the Fed might consider as an easing tool if there is a third round of easing. Basically the first option would be to talk a good game, by clearly communicating the Fed's intentions for how long it might continue to leave interest rates where they are. This could be either a timeline or a sense of a specific trigger point for tightening, such as inflation reaching a certain level. The idea is that if business had a clearer sense of what's going to happen (and not happen), there might be more incentive to invest. Unfortunately, it looks for now like Congress just might leave it to the Fed once again to try and keep economic growth in gear.